Preferred stock will generally have a voluntary conversion right -- permitting any holder of preferred stock to convert their preferred shares into common shares at any time. However, the automatic conversion refers to certain situations in which the preferred stock will automatically convert. The events that will initiate the automatic conversion are usually (1) a vote by the majority or supermajority of all the preferred stockholders voting as a single class (sometimes each separate class will need to approve), or (2) a qualified initial public offering meeting certain agreed-upon criteria.
When will the conversion right change?
The terms of the conversion can be quite confusing, but the general fact is that preferred stock will initially convert on a one-to-one basis into common stock. However, based on future financing events and other factors built into the conversion ratio, preferred stock may be converted at varying rates into common stock.
Why are conversion rights included in the term sheet?
The primary reason that these conversion rights are built into the preferred stock is to force the preferred holders to convert their stock into common immediately before an IPO. As a result of the conversion, most of the negotiated rights and preferences of the preferred stock will disappear creating a simple capitalization structure before the company goes public. Most underwriters will require that outstanding Preferred Stock convert to Common Stock in the event of an IPO. To avoid the need to negotiate this conversion at the time of an IPO, the company will negotiate a trigger price. Automatic conversion at three times the purchase price would be ideal for the Company in a first round financing but it is likely investors will expect an automatic conversion price of four to five times their purchase price.
What is negotiated in conversion rights?
While the automatic conversion itself is rarely negotiated, the criteria for a "qualified" initial public offering may be negotiated as a part of the term sheet or during the document drafting process. These criteria require that the initial public offering be priced at a minimum per share price (generally set at two to five times the purchase price of the convertible preferred) and for a minimum aggregate amount of dollars raised by the Company in the offering. The minimum aggregate offering amount is often set at $7,500,000 (the minimum amount currently required for registration on Form S-1) but the investors may request a higher threshold ($10,000,000 to $15,000,000). This requirement is intended to ensure that there will be adequate "float" (shares held by public investors) after the IPO.
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